I was, until recently, Economics Editor of The Telegraph. You can find my book - 50 Economics Ideas You Really Need to Know - here.

Britain risks default unless Government cuts public sector pensions

My column this week tries to address the question of whether Britain really deserves to be considered a “safe haven” destination for investors’ money. The condensed answer is: not entirely. At the moment markets seem to be working on the assumption that any country with its own currency should be favoured – presumably because those countries can inflate their debt away rather than having to default on it directly. Although no-one particularly approves of inflation, markets like the fact that at least this leaves a country rather more in control of its own destiny.

But does this mean Britain is really immune from default? For this one must turn to Carmen Reinhart and Ken Rogoff, who in their opus on financial crises, “This Time Is Different”. They write (emphasis mine):

Why would a government refuse to pay its domestic public debt in full when it can simply inflate the problem away? One answer, of course, is that inflation causes distortions, especially to the banking system and the financial sector. There may be occasions on which, despite the inflation option, the government views repudiation as the lesser, or at least less costly, evil. The potential costs of inflation are especially problematic when the debt is relatively short term or indexed, because the government then has to inflate much more aggressively to achieve a significant real reduction in debt service payments. In other cases, such as in the United States during the Great Depression, default (by abrogation of the gold clause in 1933) was a precondition for reinflating the economy through expansionary fiscal and monetary policy.

Now, tackling the bit in bold: on the one hand, Britain has an extremely long average debt maturity, which helps protect it from the markets. This means that despite running a far smaller deficit this year, Germany is actually issuing more debt than Britain.

But on the other front, Britain is worse-placed. As I’ve written before, I suspect that inflating away Britain’s debt will be far more difficult than some people think – because so many of Britain’s debts are index-linked – in a way that they weren’t before. If you include index-linked gilts (which weren’t around before the 70s), public sector and state pensions and PFI and local government debt, some four fifths of UK debt is linked to inflation.

The pie chart shows the breakdown of UK national debt. The green segments are linked to inflation, so cannot be eroded away by a bout of higher prices. Prices are in £bn - estimates from experts used for off-balance sheet items (the Government has in past only rarely provided official figures

This implies that inflation may not be the escape valve Britain hopes it will be. It would erode away the nominal section of the national debt, but would do nothing to reduce the other bits and pieces. They could only be slashed if the Government takes a knife to the state’s pension bill – something which is pretty easy for the state pension, which is not bound by legal contracts, though it is already pretty ungenerous. More difficult is the question of how to cut the public sector pension bill. This would mean cutting entitlements for impending retirees. Of course, this is unlikely to be achieved without a fair bit of grief – strikes, disputes, political unrest and so on.

Another possibility would be to do what a number of Chancellors have done throughout British history and refinance existing debts at lower rates. On this front, it is worth reading these two letters to the FT from a few years back by Willem Buiter (then of the LSE) and Toby Nangle of Baring Asset Management. But while this might help ease the burden, it still tackles only a proportion of the problem. In the end, unless this or the next Government tackles Britain’s public sector pensions problem, there remains a very real chance that Britain defaults on at least some proportion of its on or off balance sheet debt – whoever thought pensions could be so exciting?

PS I should offer a hat-tip to Zero Hedge for the analysis on Britain being targeted for £3bn of “shorts” in the CDS market, which you can find towards the bottom of the column.